The Great Deformation (60 page)

When the bond market turmoil came in 1994, followed by the peso crisis shortly thereafter and then by the Asian, Russian, and Long-Term Capital Management crisis as the decade unfolded, the patented fire brigade response of October 1987 was repeated with increasing intensity. Eventually the market's capacity for self-correction was eviscerated entirely, setting the stage for the toxic deformation known as “too big to fail.”

CHAPTER 15

 

W
ITHIN A FEW YEARS, THE CARNAGE OF BLACK MONDAY WAS
merely a historical footnote. It had not left a trace of damage on Main Street, meaning that the Fed had panicked for no good reason. Indeed, it had been a “neutron crash” from which the national economy emerged not only standing but actually expanding. Given that the quarter began with a stock market wipeout of immense violence, the robust 7.1 percent GDP growth rate recorded during the final quarter of 1987 was almost freakish.

Yet it would be a drastic mistake to view Black Monday as merely Wall Street sound and fury signifying nothing. The S&P 500 index had stood at nearly 340 as recently as mid-August before suddenly plunging to 225 on October 19. Other than during the 1930s, there had never been anything close to a one-third drop in the stock market in just sixty days.

BLACK MONDAY: WASTED CRISIS

Black Monday constituted a warning, therefore, but the danger it foretold was actually about the risks and instabilities accumulating within the financial system itself. Already by the late 1980s, Professor Friedman's floating money contraption had resulted in a substantial loosening of the capital and money markets from their historical moorings in the real economy.

Accordingly, what happened on Wall Street would increasingly reflect the machinations of the nation's central bank, not the economic outlook for Main Street. The stock market was no longer a mechanism for discounting corporate earnings; it was becoming a monetary slot machine for placing wagers on the actions of the nation's central bankers.

As seen previously, the Black Monday crash had been fueled and accelerated by the new tools of computerized speculation, and most especially program trading in the S&P futures pits. But the initial catalyst for the selling panic had been a mistaken reaction in the equity markets to the new Fed chairman's tightening moves within weeks of taking office in August 1987. Wall Street appeared to believe that it was dealing with another
Volcker; that is, with a successor who was reputed to be an economic conservative and who had even been tutored on the virtues of the gold standard by Ayn Rand.

Greenspan's weak-kneed response to the stock market plunge readily dispelled that misimpression. It also forfeited a golden opportunity to put financial discipline and sobriety front and center at the nation's central bank. The new Fed chairman only needed to pronounce that the American economy was healthy and to then repair to the sound money posture that Carter Glass had sketched out seventy-five years earlier. In so doing, he would have reminded Wall Street that the Fed had no dog in the equity market hunt and was therefore indifferent to fluctuations in the stock averages. Under free market capitalism, it was the job of investors, traders, and speculators, not the central bank, to determine how the stock market would value prospective corporate earnings.

By putting the stock market on life support following Black Monday, however, the Greenspan Fed crossed another monetary Rubicon. For the first time in its history, the Fed embraced the stock averages as a target of monetary policy and affirmed that the path to economic prosperity wended through the canyons of Wall Street.

This fateful decision set up the unelected branch of the state to be mugged and captured by crony capitalists as it became more deeply ensnared in the machinations of Wall Street speculators. Black Monday, therefore, constitutes another key inflection point in the long cycle of financial deformations that were triggered by the Camp David repudiation of America's external debts and domestic financial discipline.

NO TIN CUP FOR WALL STREET

The transmission mechanism between the central bank and Wall Street is a small circle of authorized, or “primary,” bond dealers who execute the Fed's open market purchase and sale of government debt. After the demise of Bretton Woods, the Fed became a chronic and massive purchaser of Treasury securities and only an infrequent seller.

This asymmetry was financially corrosive in its own right, since the Fed buys government bonds by depositing newly created cash in dealer bank accounts. In turn, the heavy flow of new cash into the banking system meant the Fed was fostering far too much cheap credit—funds which fueled speculation in commodities during the 1970s and stocks and bonds in the late 1980s and 1990s.

Yet there was an even more insidious aspect. The Fed's post–Camp David license to perpetually monetize government debt caused a dangerous
transformation of its bond dealer network. These banking houses had long been a Wall Street backwater populated by a handful of undercapitalized bond brokers who traded government securities by appointment.

During the Greenspan era, however, it became a phalanx of balance sheet powerhouses aggressively engaged in the Treasury debt moving and storage business. In practical terms, the bond dealers became a potent lobby for easy money, and for obvious reasons: falling interest rates generated windfall gains on the bond inventories carried by the primary dealers and also lowered the cost of carry on their heavily leveraged balance sheets.

Accordingly, the Wall Street pressure to monetize government debt reached toxic dimensions in the years after Black Monday. At length, the first Greenspan stock market bubble was born. Between 1987 and 1998, for example, the Fed doubled its holdings of government debt, thereby pumping freshly minted deposits into the bank accounts of Wall Street primary dealers at a 7.5 percent annual rate. This was a money-printing spree that topped even the record Arthur Burns had set during the inflationary 1970s.

What Wall Street wanted in the years after 1987, however, was the opposite of what the American economy actually needed. Given the great East Asian wage deflation then under way, the US economy needed not easy money and high living, but a regimen of frugality, including steadfastly higher interests rates to slacken household consumption, coax out greater domestic savings and investment, and encourage the sustained deflation of internal prices and costs.

The years after Black Monday thus constituted a splendid opportunity for the Fed to begin disgorging the massive $220 billion hoard of government debt it had imprudently accumulated during the Great Inflation and the Reagan deficit breakout. Selling down its government debt holdings would have forced interest rates higher—probably much higher, but a market clearing price for debt is exactly what the nation's economy required.

By that point in time, however, the primary dealers were not much interested in buying notes and bills from the Fed because that drained cash from Wall Street. Figuratively it amounted to passing a tin cup that functioned to dry-up liquidity, shrink private credit, and heighten the risks faced by speculative traders.

By forcing interest rates higher, demonetization of the public debt and shrinkage of the Fed's balance sheet would also tend to reduce the mark-to-market value of dealer bond inventories, causing lower profits and reduced bonuses. In short, there was nothing about the pathway to financial discipline and sound money that appealed to the Wall Street dealers. As they saw it, the Fed's job was just the opposite; namely, to function as their
financial concierge, supplying cash and liquidity to the markets even if it involved monetizing more and more of the federal debt.

THE REPUDIATION OF GREENSPAN 1.0

Unfortunately, the steely resolve needed to drain the Fed's balance sheet of its huge post-1971 build-up of government debt was not in Greenspan's playbook. The sound of accolades for the tech boom proved more compelling. Accordingly, the Fed continued to rapidly accumulate government debt, and thereby provide the monetary fuel for excessive private credit issuance by the banking system, even after the stock bubble moved toward parabolic extremes after May 1997.

That the Greenspan-led central bank elected to pander to Wall Street, rather than suppress the growing speculative momentum, was surprising. This type of Wall Street coddling had been tried before, in the late 1920s, to disastrous effect, and had been famously denounced by none other than Alan Greenspan himself.

In a notable 1966 essay in defense of the gold standard, Greenspan 1.0 had insisted that the source of the 1929 crash and the Great Depression which followed was that the Fed had “pumped excessive paper reserves into American banks” between 1924 and 1928. This mistaken policy had resulted in excessive growth of private credit, which “spilled over into the stock market, triggering a fantastic speculative boom.”

If there was any illusion that the late-1920s stock mania had been benign, Greenspan's indictment of the Fed's drastic error and belated attempt to reverse course dispelled all doubt. By 1929, he had noted: “It was too late … the speculative imbalances had become so overwhelming that the attempt [to tighten] precipitated a sharp retrenching and a consequent demoralizing of business confidence … the American economy collapsed … the world economies plunged into the Great Depression of the 1930s.”

Needless to say, by the mid-1990s Greenspan had apparently unlearned everything he had previously known about financial bubbles and the terrible consequences of unchecked speculative manias. His previous conviction that by 1929 it had been “too late” and that the boom should never have been fostered in the first place was likewise abandoned, if not explicitly recanted.

So it happened that the revisionist doctrines of Greenspan 2.0 took shape during the maestro's initial decade at the helm of the Fed. Not only did he shed his long-standing philosophical opposition to monetizing the federal debt, but also Greenspan 2.0 readily succumbed to pressure to feed the Wall Street dealers with a continuous flow of fresh cash.

WALL STREET'S NEW CONCIERGE:

HOW BUBBLE FINANCE WAS BORN

The Fed's capitulation to Wall Street in an economic environment which was strongly deflationary had incendiary effects in the capital and money markets. The continuous minting of fresh cash stimulated rampant credit growth by means of the shadow banking system's rehypothecation multipliers and through fractional reserve lending by conventional banks.

This outpouring of new credit was overwhelmingly used for speculation in real estate and financial assets, rather than finished goods. On the margin, the latter were increasingly priced by deflationary East Asian labor. This meant that businesses, expecting the price of goods and components to fall, did not build anticipatory stocks as they had during the 1970s. Excessive credit growth was thereby channeled to asset markets, not the goods and services in the CPI.

At the same time, there was growing realization among traders that the Fed stood ready to inject massive dollops of cash into the primary dealer market in the event of an unexpected market setback; that is, undergird the stock market with the Greenspan Put. This encouraged bolder and even more leveraged carry trades, a catalyst which accelerated asset price appreciation still further and generated even more collateralized debt creation.

The Fed's embrace after 1994 of speculation-friendly monetary policy also generated effects that reached far beyond the stock exchanges. As indicated, it enabled Wall Street to extend the tentacles of financialization deep into the nation's home finance market through thousands of mortgage boiler rooms operated out of rented Main Street storefronts. These shoestring brokers were wholly dependent upon the generous warehouse credit lines extended by Wall Street, but with no skin in the game they became dangerous dispensers of bad housing credit.

These egregious mortgage-funding arrangements were by no stretch of the imagination an invention of the free market. No banker in his right mind would have funded financial warehouses stuffed with billions of illiquid mortgages of dubious credit quality, unless he was confident that the Fed would keep interest rates pegged to its stated policy targets. Only when the Fed functioned as Wall Street's reliable concierge would dealers have sufficient time to securitize and unload these vast accumulations of raw assets to the unsuspecting. Indeed, under a Volcker-type monetary régime wherein the markets were always at risk for unexpected changes in central bank policy, it is virtually certain that the mortgage boiler rooms, and legions of like and similar vehicles of credit-based speculation, would never have gotten off the ground.

Likewise, strip malls, office buildings, and McMansion subdivisions sprang up across the nation in great profusion based on acquisition, development, and construction (ADC) loans that violated every canon of sound lending. These so-called ADC facilities were habitually underwritten at more than 100 percent of costs, allowed developers to extract huge up-front fees and profits, and depended for repayment entirely on “takeout” financing at property prices which far exceeded the present value of available cash flows.

Again, this kind of dodgy financing was rooted in the Fed's monetary largesse. Even the small community banks which originated these cheap construction-period credit lines were confident that upon project completion, borrowers could access low-cost takeout financing from the Wall Street securitization machine.